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Real estate investment trusts (“REIT’s”) are vehicles through which an investor can invest in real assets. Real assets can include real estate such as commercial and residential rental properties and hospitals, as well as other income producing real property such as timber land. REIT’s can also hold real estate related debt instruments such as mortgage backed securities.

Similar to other trusts, distributions of income, dividends and capital gains from a REIT are passed through to the investor and are not taxable to the trust entity provided that certain requirements are met.

REIT’s can be publicly traded, similar to a stock, or be closely held by a small group of investors.

REIT’s which are not publicly traded oftentimes do not have much liquidity and can be difficult for an investor to dispose of in certain cases. Such REIT’s oftentimes have higher yields which compensate investors for taking on the additional liquidity risk.

Publicly traded REIT’s, on the other hand, tend to be liquid and be relatively easy to buy and sell on an exchange. The result of this is a “liquidity premium” where an investor will typically receive a lower yield from a publicly traded REIT than from a non publicly traded REIT in exchange for the REIT having greater liquidity.

Overview

ROTH IRA and traditional IRA account contributions are subject to income phaseout limits. In the case of the ROTH IRA the limits are related to eligibility and in the case of a traditional IRA the limits are related to deducting the contributions. If you exceed these limits you may want to consider alternatives for deferring taxes on your retirement savings. There are many options available depending upon your particular situation. In general, business owners and self employed individuals have more options available to them than do W-2 employees. The details of the income and phaseout limits are discussed in detail below.

ROTH IRA income limits

You are typically able to make a ROTH IRA contribution if your income falls below certain levels. If you are married filing jointly, you can make a full ROTH IRA contribution if your modified adjusted gross income (MAGI) is less than $189,000 for the 2018 tax year. You can make a reduced contribution if your MAGI is between $189,000 and $199,000, and contributions are disallowed altogether if your MAGI is greater than or equal to $199,000.

If your tax filing status is single or head of household you may make a full ROTH IRA contribution for the 2018 tax year if your MAGI is less than $120,000, a reduced contribution if your MAGI is between $120,000 and $135,000, and no contribution at all if your MAGI is greater than or equal to $135,000.

If you are not able to make a ROTH IRA contribution due to income restrictions, you may want to investigate whether or not your employer offers a ROTH 401K plan. If they do not, you should consider making a request to your employer that a ROTH 401K plan be implemented.

ROTHIRA income limits for 2018 tax year

filing status

income limit

Married filing jointly

full contribution allowed for MAGI less than $189,000; phaseout for MAGI between $189,000 and $199,000, no contribution allowed for MAGI greater than or equal to $199,000

Single

full contribution allowed for MAGI less than $120,000; phaseout for MAGI between $120,000 and $135,000, no contribution for MAGI greater than or equal to $135,000

Head of household

full contribution allowed for MAGI less than $120,000; phaseout for MAGI between $120,000 and $135,000, no contribution for MAGI greater than or equal to $135,000

Married filing jointly (and lived with spouse at any time during year)

phaseout for MAGI between $0 and $10,000, no contribution for AGI greater than or equal to $10,000

Traditional IRA income limits

There are no income restrictions related to making a contribution to a traditional IRA, however you may not be able to deduct the contributions if you or your spouse participates in a retirement plan at work. If you or your spouse participate in a retirement plan at work, the deduction begins to phaseout at $63,000 MAGI for single or head of household ($101,000 for married filing jointly) and phases out completely at $73,000 MAGI ($121,000 for married filing jointly). These numbers are for the 2017 tax year. If you are in this situation, you should consider contributing to your retirement plan at work, such as a 401K plan, as you will be able to deduct these contributions up to their limit.

TraditionalIRA income limits for 2018 tax year

filing status

no retirement plan at work

retirement plan at work

spouse has retirement plan at work (and you do not)

Married filing jointly

no limits

full deduction up to contribution limit if MAGI less than $101,000, partial deduction for MAGI between $101,000 and $121,000, no deduction if MAGI is greater than $121,000

full deduction if MAGI less than $189,000, phaseout for MAGI between $189,000 and $199,000, no deduction if MAGI is greater than $199,000

Single

no limits

full deduction up to contribution limit if MAGI less than $63,000, partial deduction for MAGI between $63,000 and $73,000, no deduction if MAGI is greater than $73,000

N/A

Head of household

no limits

full deduction up to contribution limit if MAGI less than $63,000, partial deduction for MAGI between $63,000 and $73,000, no deduction if MAGI is greater than $73,000

N/A

Married filing separately

no limits

partial deduction for MAGI between $0 and $10,000, no deduction if MAGI is greater than or equal to $10,000

partial deduction for MAGI between $0 and $10,000, no deduction if MAGI is greater than or equal to $10,000

Health savings accounts (“HSA’s”) provide a means for an individual or family to self insure all or a portion of their medical expenses. Contributions can be made up to a certain annual limit, and the balance carries forward from year to year. They are designed to be supplemented with a high deductible health insurance plan (“HDHP”), a medical insurance plan which covers medical expenses and, as its name implies, has a high deductible. Premiums for high deductible health plans are typically much lower than for other health insurance plans, so by saving in an HSA the individual or family is self insuring a portion of their medical expenses and by doing so is saving on premium expenses.

Health savings accounts have several tax advantages. Contributions made to HSA’s are tax deductible in the year in which they are made, grow on a tax deferred basis, and are tax free when withdrawn, as long as they are used to pay for medical expenses. Unlike traditional IRA accounts, HSA accounts are not subject to required minimum distribution rules. For the 2018 tax year, the contribution limits for health savings accounts are $3,450 for an individual and $6,900 for a family, with an additional $1,000 “catch up” contribution for individuals 55 and older. Contributions can be made to an HSA up until age 65, after which point the funds in the HSA can be used to fund out of pocket costs associated with medicare.

Allocating commodities to an investment portfolio can add many benefits to the portfolio including inflation protection and diversification. Commodities can include metals such as gold, silver and copper; natural resources such as crude oil and natural gas; agricultural products such as corn, sugar, wheat, soybeans, and coffee; and livestock such as cattle and hogs.

Commodities are typically purchased via futures contracts, which trade on a exchange. Market participants in the commodity futures markets include speculators and hedgers. Speculators buy and sell futures with the intention of profiting from their transactions, while hedgers purchase futures to protect their business from price fluctuations.

Adding commodities to an asset allocation can be beneficial in several ways. Such an allocation can provide protection against inflation by providing a hedge against a weakening currency. It can also reduce the risk in a portfolio by providing diversification away from more traditional assets such as stocks and bonds.

Futures contracts traded on U.S. exchanges are taxed according to the “60/40” rule. As per this rule, contracts are taxed at long term capital gains rates of 60% and short term capital gains rates of 40%. This rule applies regardless of how long the contracts are held, making futures contracts more attractive than stocks and bonds for short term trading.

Sovereign bonds are debt instruments issued by national governments. They are one of the least risky debt instruments as they are typically backed by tax revenue and the ability of the sovereign nation to issue additional debt. They usually pay a lower yield than corporate bonds due to the stability and reliability of their collateral. Keep in mind that not all sovereign nations have favorable credit ratings, and the risk and corresponding yield will vary according to the quality of the underlying collateral.

Many sovereign governments issue what are known as inflation protected bonds, whose value is linked to an inflation related benchmark such as the consumer price index.

Similar to corporate bonds, treasury bonds trade over the counter through financial institutions known as market makers or dealers.

Like any other bond or fixed income instrument, sovereign bonds are subject to interest rate risk. The interest rate risk of the bond increases as the duration of the bond increases.

Sovereign bonds tend to be the least risky asset class, and accordingly also typically offer the lowest rate of return. They can provide a valuable addition to an investment portfolio when combined with other asset classes such as common stocks, preferred stocks, and corporate bonds.

Small cap stocks are publicly traded equity interests in smaller companies, typically companies with $1 – $5 billion in market capitalization and less. Unlike most large cap stocks, which include household names such as IBM, Apple and Google, small cap stocks tend to be less well known to the public. As an asset class, they tend to have more risk and be more volatile than large cap stocks. This is mostly due to the fact that smaller firms have less access to capital and are less diversified in their operations than larger firms.

Historically small cap stocks have, generally speaking, outperformed their larger capitalization counterparts over the long run. This is due to the fact that small firms oftentimes have a smaller market share, and therefore have more room for growth than larger firms, who may have already captured a large share of the market in which they operate. As a result, smaller firms are oftentimes able to grow and expand their market share, revenues and earnings at a higher rate than larger firms.

Due to their relatively high volatility and risk, small cap stocks are best suited for investors with longer time horizons and higher risk tolerances. For the right investor, small cap stocks can play an important and valuable role in his or her overall asset allocation. By combining them with other asset classes such as domestic large cap stocks, international stocks and fixed income instruments, the portfolio can be tailored to the risk tolerance and time horizon of the investor.

Exchange traded funds (“ETFs”) are securities which trade on an exchange and usually track a stock, bond, or commodity index. Unlike an open end mutual fund, whose price is calculated daily at market close, exchange traded funds trade throughout the day and their price is determined by supply and demand. Unlike a closed end mutual fund, whose market price frequently deviates from its net asset value due to supply and demand imbalances, ETFs are created and redeemed by certain market participants, resulting in additional liquidity and market prices which tend to more accurately reflect their net asset value.

Exchange traded funds tend to have lower expense ratios than mutual funds as they are usually passive and oftentimes track a stock index such as the S&P 500 (U.S. large cap equity), Russell 2000 (U.S. small cap equity), or EAFE (Europe, Asia, Far East equity). They can also track a bond index such as the Barclays Aggregate Bond Index, or a commodity such as gold, silver or oil. They thus provide a way for an investor to obtain exposure to an asset class in a low cost, passive manner.

Exchange traded funds are typically structured as corporations or investment trusts, and the investor is thus entitled to dividends and interest generated by the underlying assets of the funds. Similarly, the investor is entitled to proceeds from the sale of the underlying assets upon liquidation of the fund.

Equity exchange traded funds are usually more tax efficient than open end mutual funds. This is due to the fact that ETF shares are created and redeemed in a manner which allows the share holder to have a cost basis in the fund which closely tracks the cost basis of the underlying assets of the fund.

Corporate bonds are debt instruments issued by private enterprises, and are sometimes backed by tangible assets of the company issuing the bond. They generally have more credit risk than sovereign bonds due to the fact that they are backed by corporate revenue, which is less reliable than tax revenue. They tend to have higher yields than sovereign bonds, although this is not always the case.

Unlike common stock and preferred stock shares which trade on an exchange, corporate bonds trade over the counter through certain market participants known as market makers. Market makers tend to be large financial institutions such as banks, broker dealers and insurance companies. Corporate bonds typically trade at a level based on internal factors such as the credit risk of the issuer as well as external factors such as interest rates.

Corporate bond holders have a higher claim on company assets and equity than preferred stock holders, and the interest payment on corporate bonds is typically lower than the dividend payment on preferred stock shares. The interest payment is taxable to the bond holder at the federal, state and local level.

As an asset class, corporate bonds are less risky than both preferred stock shares and common stock shares, and typically offer a lower rate of return. They are more risky than most sovereign bonds and offer a higher rate of return.

Master limited partnerships (“MLP’s”) are limited partnership interests in businesses which trade publicly on an exchange, similar to a stock. Unlike stocks, which are typically structured as corporations under state law and therefore subject to double taxation, master limited partnerships avoid double taxation by directly passing their profits through to limited partners.

Master limited partnerships typically involve businesses in the energy sector, such as oil and natural gas production, storage, transportation and distribution. Because they are contractually required to make distributions to limited partners on a periodic basis, they usually consist of businesses with predictable revenue streams and long term contracts.

As an asset class, MLP’s tend to be less volatile than stocks, although this is not always the case. Because a reasonable portion of the distributions which are paid to unit holders are return of capital rather than income, limited partners can defer taxes on their distributions until their units are sold. When the units are finally disposed of by the limited partners, the proceeds will be taxed at the capital gains rate.

Taxation and reporting of MLP’s is complex and can cause an administrative burden for many individual investors. Many of these issues can be avoided by holding these units in retirement accounts such as IRA and 401K accounts, where such reporting is in many cases not required.

Annuities are tax deferred savings contracts that are usually written by insurance companies. The owner of the contract makes a payment or series of payments to the issuer or insurer and in return the insurance company promises to make a payment or series of payments to the contract owner in the future. Although they have a reputation for having high fees, they can be advantageous in a variety of situations, including tax deferral as well as insuring against longevity risk of the annuitant and/or owner. Unlike qualified plans such as 401K and 403B plans and IRAs, there is no annual limit to how much can be contributed to an annuity contract.

Tax deferral

Annuities allow the contract owner to defer taxes on gains inside the contract until their withdrawal. When withdrawals are made, they are subject to first in first out (“FIFO”) reporting, in that the gains will be deemed to have been withdrawn first, and will thus be subject to taxes. The contract owner will be subjected to a 10% penalty on withdrawals if the withdrawals are made prior to age 59 1/2. Taxes on the gains upon withdrawal can be deferred and paid on a prorated basis by taking withdrawals on a periodic basis.

Management of longevity risk

Annuities provide a way to protect the contract owner against longevity risk. As an example, consider an individual who, at retirement age, has a lump sum which needs to last through retirement. If the retirement income strategy is to withdraw income only and preserve the principal, then there are no issues and an annuity may not be suitable or necessary. However, if the retirement income strategy is to withdraw the lump sum gradually over many years, it is difficult to assess how much should be withdrawn as there is no way to know for how many years the withdrawals will be needed. An annuity can protect against this uncertainty by making payment until the death of the annuitant.

The enrolled agent designation is the highest credential awarded by the IRS. Like attorneys and certified public accountants, enrolled agents are empowered to represent clients before the IRS for all matters including audits, collections and appeals. The details of the rights and responsibilities of enrolled agents can be found in Treasury Department Circular 230.

To become an enrolled agent, one must typically obtain a preparer tax identification number (PTIN), pass three comprehensive exams (known as the “special enrollment exams”), and pass a suitability and tax compliance check. One may also obtain relevant experience as an IRS employee in lieu of passing the special enrollment exams.

To maintain their designation, enrolled agents must complete 72 hours continuing education requirements every three years, adhere to rigorous ethical standards, and maintain their PTIN by paying relevant renewal fees.

Closed end funds are, as discussed previously, mutual fund shares which trade on an exchange much like a stock. Like open end funds, they are registered as investment companies under the Investment Company Act of 1940 and are highly regulated. Unlike open end funds, which are priced at the end of the day and valued based upon the holdings in the fund, the market price of a closed end fund is determined by supply and demand for the fund on an exchange.

This results in a closed end fund having a market price which can at times vary significantly from its net asset value. As discussed previously, this discrepancy can create an opportunity for an investor to buy fund shares at a discount to net asset value and sell fund shares at a premium to net asset value.

Closed end fund shares are issued once during an initial public offering, after which point shares can only be obtained by purchasing them from other shareholders. This is on contrast to an open end fund, whose operators have the ability to create and redeem shares in reaction to capital flowing in and out of the fund.

Closed end funds tend to be capitalized in the $100 million to $1 billion range, which is much smaller than the typical open end fund, which oftentimes has a market capitalization exceeding $10 billion. Closed end funds oftentimes employ leverage to boost returns, and frequently pay dividends and interest exceeding 6% per annum.

Preferred stock is equity interest in a company which is has a higher claim to company equity and assets than common stock and a lower claim to company equity and assets than bonds. Preferred shares typically pay higher dividends than common stock, and dividends must be paid to preferred stock shareholders prior to being paid to common stock shareholders.

Unlike common stock shares, preferred shares typically do not entitle their holder to voting rights. Publicly traded preferred shares are issued by financial institutions such as banks and insurance companies, real estate investment trusts, and utilities.

Preferred stock can be either cumulative or non-cumulative. If a dividend payment for cumulative preferred shares is missed, it will accumulate and be due in a future payment. This is in contrast with non-cumulative preferred shares, for which no future dividend payment is due if one is missed.

As an asset class, preferred shares tend to be less volatile than common stock shares and more volatile than bonds. While they tend to pay higher dividends than common stock shares, they offer less opportunity for capital appreciation. While they typically pay more in dividends than bonds pay in interest, they have greater credit risk than bonds and therefore tend to be more volatile.

As an investor, a primary goal is to manage the risk in the investment portfolio, and this is typically accomplished by allocating capital across different asset classes. Which asset allocation is appropriate is dependent upon the time horizon, risk tolerance, and investment objectives of the investor as well as other external factors.

Strategic asset allocation versus tactical asset allocation

At the most basic level, asset allocation models are oftentimes classified as “strategic” or “tactical”. A strategic asset allocation is based upon the time horizon, risk tolerance and investment objectives of the investor, while a tactical allocation takes into account market conditions, economic and political factors, security analysis, and other factors external to the situation and needs of the individual investor.

Strategic asset allocation

The strategic allocation will depend on factors unique to the investor. For example, for a risk averse individual with a short time horizon the ideal strategic asset allocation will likely consist of a large amount of bonds and cash and a small amount of stocks, whereas for an aggressive investor with a long time horizon the ideal strategic asset allocation will likely consist of a large amount of stocks and a small amount of bonds. When constructing a strategic allocation, a common rule of thumb is to base the bond allocation in the portfolio on the investor’s age.

For example, a 30 year old investor using this method would allocate 30% of the portfolio to bonds and cash and the remaining 70% to stocks, whereas a 65 year old investor would allocate 65% of the portfolio to bonds and cash and the remaining 35% to stocks. Of course, this is only a rule of thumb should be used in conjunction with the time horizon and risk tolerance of the investor as well as other factors related to the financial situation of the investor. We emphasize the importance of consulting with the appropriate advisers in implementing an asset allocation and a corresponding investment program.

Tactical asset allocation

Tactical asset allocation involves taking into account factors external to the needs and attributes of the investor. Factors include economic, political, and market conditions. For example, if the investor and/or investment manager believe that a recession is imminent, they may consider reducing exposure to equities and making a corresponding increase in the exposure to bonds and cash. Another example involves factors related to the financial position of the individual company or companies in question, and the capital structure represented by the corresponding securities which are involved. In this scenario, the investor may consider increasing exposure to those securities which are believed to be undervalued and decreasing exposure to those securities believed to be overvalued.

High yield bonds, frequently referred to as “junk bonds”, are debt obligations of companies which are considered to be high credit risks. They typically pay a higher yield than investment grade bonds to compensate investors for taking on additional risk.

Like all corporate bonds, junk bonds typically trade over the counter through dealers and their liquidity depends on a variety of factors.

Oftentimes investment grade bonds will be downgraded due to business difficulties of the issuer, and begin trading at a significant discount to their par value as a result. Such issues are frequently referred to as “fallen angels”. These junk bonds should be viewed by prospective investors with caution as they could be an indication of an imminent default of the issuer.

As an asset class, high yield bonds tend to be slightly less risky than stocks, and significantly more risky than most investment grade corporate bonds.

Like all fixed income instruments, junk bonds are susceptible to interest rate risk, which increases as the duration of the bond increases.

Junk bonds can be a valuable addition to an investment portfolio, however caution should be taken before allocating them to accounts whose owner has a short time horizon or low risk tolerance.

Health maintenance organization (HMO)

Health maintenance organizations provide coverage from entirely within their network of providers. These plans typically have lower administrative costs and less paperwork than other plans. Members usually must obtain a referral on order to proceed with receiving care from another provider.

Preferred provider organization (PPO)

In a preferred provider network members can receive care from inside or outside the network, but typically have higher out of pocket costs when outside the network in the form of higher deductibles and co-insurance.

Exclusive provider organization (EPO)

Exclusive provider organizations are similar to HMO plans except that referrals are usually not needed.

Point of service (POS)

Point of service plans are similar to HMO plans except that care can be obtained from outside the network. Referrals are typically needed in order to do so, and costs borne by the member are usually higher.

High deductible health plan (HDHP)

High deductible health insurance plans are typically the lowest cost plans, but also have high deductibles and usually high co-insurance payments as well, resulting in high out of pocket costs overall. These plans are usually supplemented with health savings accounts (“HSA”s) which enable the member to accumulate assets on a tax advantaged basis for the purposes of paying for out of pocket costs associated with the high deductible health plan.

How the cost basis of an investment is determined will have a significant impact on how the investment is taxed when sold. Here we will provide an overview of some of the most common cost basis conventions which are currently being used in the tax code for the 2016 and 2017 year.

First in, first out (FIFO)

With this method, the shares or units which were purchased first are the ones which are used to determine the basis when the asset is disposed of. Another way of looking at this is that the shares which remain are the shares which were most recently purchased. As an example, let’s say you purchase 100 shares of XYZ stock on September 1, 2016 for $5 per share, purchase another 50 shares of XYZ stock on October 1, 2016 for $10 per share and then sell 100 shares of XYZ stock on November 1, 2016 for $15 per share. When using the FIFO method the basis for these shares would be $5 per share, or the price paid for the first 100 shares of XYZ stock on October 1, 2016.

Specific share identification (Spec ID)

With this method, the specific shares are identified upon the disposal of those shares. Using the example above: upon selling the 100 shares of XYZ stock on November 1, 2016, these shares could be identified as the shares purchased on October 1, 2016, resulting in a basis of $10 per share, in contrast with the basis of $5 per share which would be the result of using the FIFO method.

Average cost single category

With this method, the average cost of the shares is calculated by dividing the total dollar amount of the purchases by the total number of the corresponding shares or units. Using the example above, the total number of shares purchased would 150 and the total dollar amount of shares purchased would be $1,000, resulting in an average cost basis of $6.67 per share.

Highest in, first out

With this method, the shares with the highest cost are the shares which are sold or disposed of. The purpose of using this method is to minimize the taxable gain within a specified period. Using the example above, the 100 shares sold on November 1, 2016 would be identified as the 50 shares purchased on October 1, 2016 for $10 per share plus 50 of the shares purchased on September 1, 2016 for $5 per share. The basis in this case would be $7.50 per share, which is the total dollar amount of the shares purchased divided by the number of shares sold.

Minimum tax

Under the minimum tax method, shares are sold in the order which minimizes taxable gains and maximizes tax deductible losses. Specifically, shares are sold in the following order: maximum short term capital losses, maximum long term capital losses, minimum long term gains and finally minimum short term gains.

Maximum gain

This method is the exact opposite of the minimum tax method in that it will tend to maximize the taxable gains, and would only be used in a situation where such an outcome would be advantageous, for example to offset against losses. Using the maximum gain method, shares are disposed of in the following order: maximum short term gains, maximum long term gains, minimum long term losses an finally minimum short term losses.

401K plans and their cousins, 403B plans (as well as 457 plans and Federal Thrift Savings Plans – these types of plans are collectively known as “qualified” plans) provide a great way to save for retirement. Employee contributions are tax deductible, and the earnings are tax deferred until their withdrawal. There are no earnings restrictions as there are with IRA accounts, and this applies to traditional 401K as well as ROTH 401K contributions. Making contributions to a 401K or 403B plan is convenient as it is typically withheld from the employee’s paycheck. Oftentimes, employers will match employee contributions, and sometimes they will make additional profit sharing contributions as well.

The maximum which an individual may contribute to a 401K or 403B plan is $18,000 for the 2017 tax year. Persons 50 or older may contribute an additional $6,000 per year. These employee contributions are deferred from the salary of the plan participant, and are not included in the participant’s adjusted gross income. Employer matching contributions are determined by the employer’s policy and are usually specified in the plan documents and summary plan description.

How much you should contribute to your 401K plan will depend upon your age, income, tax bracket, and investment objectives and retirement goals. It is recommended, however, that you “max out” the employer match if there is one. Not doing so will leave money on the table which would have been easy to obtain.

SEP-IRA retirement plans

A SEP-IRA account is the same as a traditional IRA in most ways. The only substantial difference is that with a SEP-IRA, the participant can contribute up to 25% of compensation, or $54,000 for 2017 ($60,000 for persons ages 50 or older), whichever is lesser. This could end up being substantially more than the contribution limit for a traditional IRA account, depending on the compensation of the participant. In order to be eligible to establish a SEP-IRA, you must own a business (this includes being self employed). If you have any employees, they are eligible to have a SEP account as well, and must be included if they meet certain criteria (worked for the business for 3 of the previous 5 years, attained age 21, and had at least $600 in compensation. These requirements can be made less restrictive in the SEP-IRA plan document). SEP-IRAs have the main advantage of being easy and relatively inexpensive to administer.

401K retirement plans

A business owner, including a self employed person, has the option of establishing a 401K plan for his or her self and employees. The participant can contribute 100% of compensation, up to the limit ($18,000 for 2017 plus a $6,000 “catch-up” contribution if age 50 or older). The business owner can also make a non-elective contribution of up to 25% of compensation. The rules related to the non-elective contribution are a bit more complex for a self employed individual but are in the same general range. 401K plans are in general a bit more time consuming and costly to administer than SEP-IRA plans, however they have the main advantage of having larger contribution limits than SEP-IRAs. They also allow the participant to take loans against their 401K balance, something which is prohibited by the IRS rules pertaining to IRAs, including SEP-IRAs.

Overview

ROTH IRA and traditional IRA account contributions are subject to income phaseout limits. In the case of the ROTH IRA the limits are related to eligibility and in the case of a traditional IRA the limits are related to deducting the contributions. If you exceed these limits you may want to consider alternatives for deferring taxes on your retirement savings. There are many options available depending upon your particular situation. In general, business owners and self employed individuals have more options available to them than do W-2 employees. The details of the income and phaseout limits are discussed in detail below.

ROTH IRA income limits

You are typically able to make a ROTH IRA contribution if your income falls below certain levels. If you are married filing jointly, you can make a full ROTH IRA contribution if your adjusted gross income (AGI) is less than $186,000 for the 2017 tax year. You can make a reduced contribution if your AGI is between $186,000 and $196,000, and contributions are disallowed altogether if your AGI is greater than or equal to $196,000.

If your tax filing status is single or head of household you may make a full ROTH IRA contribution for the 2017 tax year if your AGI is less than $118,000, a reduced contribution if your AGI is between $118,000 and $133,000, and no contribution at all if your AGI is greater than or equal to $133,000.

If you are not able to make a ROTH IRA contribution due to income restrictions, you may want to investigate whether or not your employer offers a ROTH 401K plan. If they do not, you should consider making a request to your employer that a ROTH 401K plan be implemented.

ROTHIRA income limits for 2017 tax year

filing status

income limit

Married filing jointly

full contribution allowed for AGI less than $186,000; phaseout for AGI between $186,000 and $196,000, no contribution allowed for AGI greater than or equal to $196,000

Single

full contribution allowed for AGI less than $118,000; phaseout for AGI between $118,000 and $133,000, no contribution for AGI greater than or equal to $133,000

Head of household

full contribution allowed for AGI less than $118,000; phaseout for AGI between $118,000 and $133,000, no contribution for AGI greater than or equal to $133,000

Married filing jointly (and lived with spouse at any time during year)

phaseout for AGI between $0 and $10,000, no contribution for AGI greater than or equal to $10,000

Traditional IRA income limits

There are no income restrictions related to making a contribution to a traditional IRA, however you may not be able to deduct the contributions if you or your spouse participates in a retirement plan at work. If you or your spouse participate in a retirement plan at work, the deduction begins to phaseout at $62,000 AGI for single or head of household ($99,000 for married filing jointly) and phases out completely at $72,000 AGI ($119,000 for married filing jointly). These numbers are for the 2017 tax year. If you are in this situation, you should consider contributing to your retirement plan at work, such as a 401K plan, as you will be able to deduct these contributions up to their limit.

TraditionalIRA income limits for 2017 tax year

filing status

no retirement plan at work

retirement plan at work

spouse has retirement plan at work (and you do not)

Married filing jointly

no limits

full deduction up to contribution limit if AGI less than $99,000, partial deduction for AGI between $99,000 and $119,000, no deduction if AGI is greater than $119,000

full deduction if AGI less than $186,000, phaseout for AGI between $186,000 and $196,000, no deduction if AGI is greater than $196,000

Single

no limits

full deduction up to contribution limit if AGI less than $62,000, partial deduction for AGI between $62,000 and $72,000, no deduction if AGI is greater than $72,000

N/A

Head of household

no limits

full deduction up to contribution limit if AGI less than $62,000, partial deduction for AGI between $62,000 and $72,000, no deduction if AGI is greater than $72,000

N/A

Married filing separately

no limits

partial deduction for AGI between $0 and $10,000, no deduction if AGI is greater than or equal to $10,000

partial deduction for AGI between $0 and $10,000, no deduction if AGI is greater than or equal to $10,000

Below are the income tax brackets for the 2017 tax year. These are the marginal tax rates, in that you will be taxed at each of these levels as your income rises. For example, if you are single and had taxable income of $60,000, your tax would be the sum of 10% of $9,325, 15% of $28,625 ($37,950 minus $9,325), and 25% of $22,050 ($60,000 minus $37,950). Capital gains tax brackets are different from income tax brackets.

ROTH 401K and ROTH IRA accounts provide retirement savings options which are fully tax free upon withdrawal as long as they comply with certain IRS rules. A disadvantage of ROTH IRA accounts is that they are restricted to lower income earners. In order to contribute to a ROTH IRA for the 2017 tax year, your adjusted gross income must be less than $196,000 if you are married filing jointly and less than $133,000 if you are filing as single or head of household, and the amount of the allowable contribution phases out as it approaches these limits.

A ROTH 401K plan, unlike a ROTH IRA, has no income limits for the participant. Regardless of income, for the 2016 tax year an individual may contribute up $18,000 to a 401K account (ROTH or traditional). This limit increases to $24,000 for participants age 50 or older. Unlike a traditional 401K plan, contributions made to a ROTH 401K are made on an after tax basis. Keep in mind that employer contributions to a 401K plan, unlike ROTH 401K employee contributions, are always taxable to the plan participant upon their withdrawal.

Whether or not a high income earner should contribute to a ROTH 401K plan depends on a variety of factors. On one side of the argument, a high income earner is in a high tax bracket and may be better off contributing to a traditional 401K as the immediate tax benefit could be significant. On the other hand, ROTH 401K accounts have numerous advantages related to tax free withdrawals as well as limited rules related to required minimum distributions. A careful analysis should be done of your financial situation, with particular attention paid to your tax bracket now and your expected tax bracket in retirement.

Overview

Individual retirement accounts (“IRAs”) provide an excellent option for funding your retirement due to their numerous tax advantages. They are typically administered by a financial institution such as a bank, broker/dealer, trust company or insurance company, which acts as the trustee for the account. There are many types of IRAs, including SEP IRAs, SIMPLE IRAs, rollover IRAs, traditional IRAs, and ROTH IRAs. The two most common types of IRAs are ROTH IRAs and traditional IRAs, which I will review in detail here. Each of these retirement savings vehicles has its advantages and disadvantages from a tax perspective. Which one is more advantageous for your particular situation will depend on a variety of factors, including your age, time horizon, income (and tax bracket), investment objectives, and expected income and tax bracket in retirement. In most cases I believe that a ROTH IRA provides a greater benefit overall however I will review in detail the advantages and disadvantages of both of these retirement savings vehicles in this article.

*deduction subject to phaseout limits if you have a retirement plan at work

IRA Contributions

For both the traditional IRA and ROTH IRA an individual may contribute up to $5,500 if under the age of 50, and up to $6,500 if age 50 or over per tax year, for 2016 and 2017. However, an individual may not contribute more than their employment income. ROTH IRA contributions are also subject to income limits. While traditional IRAs do not have income limits, you may not be able to deduct contributions if you or your spouse have a retirement plan, such as a 401K or 403B plan, at work.

Traditional IRA – take a tax deduction now, pay taxes later

As long as you are not subjected to certain income phaseout limits, IRA contributions are tax deductible in the year in which they are made. You will, however, have to pay ordinary income taxes on the withdrawals. You will also be subjected to a penalty tax if you make withdrawals prior to age 59 1/2 (unless you qualify for certain exceptions). Money invested in a traditional IRA grows tax deferred, so you will not have to pay taxes related to the growth or income in the account until you start taking withdrawals from the IRA. You can make contributions to a traditional IRA up until age 70 1/2, after which point you will need to take a required minimum distribution each year (this is true for SEP and SIMPLE IRAs as well). The amount of the required minimum distribution which you must take increases each year based upon your age according to mortality tables which are part of the IRS code. The required minimum distribution rule makes it difficult for the account holder to continue to grow the account after age 70 1/2 as funds must be withdrawn from the account every year, thus subjecting these funds to income taxes.

Even if you do not qualify to take a deduction for your traditional IRA contribution, you can still benefit from its tax deferral feature. However, you may be better off making a contribution to a 401K plan instead, as you will be able to deduct your contributions there up to the limit.

ROTH IRA – no tax deduction now, withdraw tax free later

ROTH IRA contributions are not deductible in the year in which they are made. However, ROTH IRA withdrawals are not taxed as long as the ROTH IRA has been in existence for at least five years and are taken after age 59 1/2 (if either of these criteria are not met, the earnings on the ROTH IRA are subject to a 10% penalty tax). ROTH IRA contributions can be made at any age, and there are no required minimum distributions as there are with a traditional IRA. These features make the ROTH IRA a very attractive choice for retirement because the account holder is able to keep the funds in the account for extended period of time, where they can continue to grow and compound tax free. The account holder has the option to withdraw portions of the ROTH IRA assets to fund retirement, and is able to do so tax free, but is not required to.

Money market funds are widely considered to be some of the most conservative and least risky investments. They are typically structured as open end funds which hold liquid assets such as short term loans and obligations. Specifically, their holdings tend to consist of treasury bills and commercial paper which have maturities of less than a year. Such funds are taxable at the federal level. In some cases the funds are composed of municipal securities with short time horizons (less than a year). Such municipal funds are typically exempt from taxation at the federal level and are suitable for investors in higher tax brackets.

Money market funds are liquid and can typically be converted to cash within one business day. They are suitable for investors with very short time horizons (less than a year) and low risk tolerance. They are frequently used to fund short term needs such as emergency funds and current liabilities.

Money market funds held at banks are typically insured by the FDIC (Federal Deposit Insurance Corporation) and are considered as safe as bank deposits. Most, but not all, money market funds held in brokerage accounts at broker-dealers are not FDIC insured. These non-insured funds are generally considered to be low risk, however investors should be aware that they are not as safe as FDIC insured bank deposits.

The Certified Financial Planner™ (CFP®) designation is a professional designation which is frequently held by financial planners, investment advisers and other financial advisers. It is conferred by the Certified Financial Planner Board of Standards, Inc. Candidates must have a bachelor’s degree (or higher) from an accredited college or university, three years of full-time personal financial planning experience and complete a course of study in financial planning topics. These subject areas include investments, taxes, estate planning, insurance planning, employee benefits, and asset protection.

A candidate may be exempt from the course of study requirement if he or she holds a CPA, ChFC, CLU, CFA, Ph.D in business or economics, a Doctor of Business Administration, or an attorney’s license.

All candidates must successfully complete the CFP® Certification Examination, which has a reputation for being very challenging, comprehensive and arduous.

CFP® practitioners are subject to the CFP Board’s ethical standards, and must abide by a fiduciary standard.

Certificants must typically complete 30 hours of continuing education every two years, and 2 hours of these 30 hours must be in topics related to ethics.

In many jurisdictions, the CFP® designation will exempt an investment adviser representative from having to pass the Series 65 examination.

Trusts provide a way to preserve and protect assets, as well as pass assets to heirs outside of the probate process. They are frequently utilized in estate planning to minimize estate taxes. They can also be used to protect assets by moving assets away from the grantor. Trusts are typically formed under state law, however unlike corporations and LLC’s they are not usually registered with the state in which they are formed.

Trusts usually have grantors, trustees, and beneficiaries. The grantor contributes assets to the trust and executes the formation of the trust. The trustee is designated by the grantor, who manages the trust assets for the benefit of the beneficiaries according to the terms laid out in the trust.

A trust can be revocable or irrevocable. A revocable trust, frequently referred to as a living trust, allows the grantor to retain control of the assets while at the same time allowing those assets to pass outside of the probate process. A revocable trust typically does not enable the trust assets to avoid estate taxes.

An irrevocable trust, on the other hand, involves the transfer assets out of the grantor’s name and typically causes the grantor to lose control of those assets. Because these assets are transferred out of the grantor’s estate, they typically avoid estate taxes in many circumstances.

Which business structure you choose for your small business is an important decision from an operational and administrative perspective as well as from a legal and tax perspective. It is important to review your individual situation with the appropriate advisers. We will provide an overview of some of the most common business structures here.

Corporation

A corporation has numerous advantages. A corporation is typically formed by filing articles of incorporation with the relevant state authorities. A corporation has directors, officers, and shareholders. Shareholders have a representative ownership interest in the corporation, and are able to exercise their rights by voting their shares. Directors are elected by the shareholders, and the directors appoint the officers, who manage the corporation on behalf of the shareholders. In most cases shareholders are shielded from personal liability related to the activities of the corporation. Corporations can be taxed as either a “C” corp or as an “S” corp at both the federal and state level. A C corp files its own tax return and pays its own taxes, whereas an S corp for the most part is taxed by passing its income through to the individual shareholders.

C corporation – taxation overview

Corporations, which are organized and filed under state law, can elect to be treated as either a C corporation or an S corporation for federal tax purposes. Corporations typically must have officers and directors who supervise and direct their business activities. Each corporate structure has advantages and disadvantages related to taxation and shareholder composition. We will provide a very basic overview of the C corporate structure here.

C corporation earnings are subject to corporate taxes at the federal level. A corporation must file its own federal tax return, and must pay its own taxes. Corporate taxes are levied at a progressive rate according to the corporation’s total earnings. An exception to this is the personal service corporation, whose earnings are taxed at a flat rate regardless of total income.

When corporate earnings are distributed to shareholders via dividend payments, the shareholders are taxed on the income received as a result of these dividends. As a result, these earnings are taxed twice: once to the corporation and again to the shareholder. This is frequently referred to “double taxation”, and is a major disadvantage of the structure of c corporations from a taxation perspective.

Advantages of c corporations include an unlimited number of shareholders as well as minimal restrictions related to the composition of these shareholders. This is in contrast to S corporations, which have more stringent rules. For example, S corporations can not have more than 100 shareholders, and those shareholders can only be U.S. citizens and residents, and must be natural persons.

In certain cases, non dividend distributions can be made by a corporation to its shareholders. This would occur, for example, in the case of a liquidation of the corporate assets. Such distributions would be treated as either return of capital or capital gains to the shareholder, depending on the circumstances.

S corporation – taxation overview

As discussed previously, corporations, which must be filed under state law and have both officers and directors, can elect to be taxed as either an S corporation or a C corporation at the federal level. We discussed the basics of C corporations previously. Here we will discuss the basics of S corporations and their advantages and disadvantages related to taxation, shareholder composition, and stock classification.

S corporations are considered pass through entities from a taxation perspective. Accordingly, the S corporation itself does not pay any taxes on its earnings, but instead passes those earnings (and gains) directly through to its shareholders. The S corporation must file its own tax return, however typically there is no tax due at the corporate level. As the income is passed though, the shareholders are responsible for paying taxes on their share of the income. This is a major advantage of the S corporation structure as there is no “double taxation” as is the case with C corporations.

S corporations have several disadvantages, however, mainly related to restrictions on the composition of their shareholders and classification of their stock. An S corporation can have a maximum of 100 shareholders, and these shareholders can only be natural persons who are U.S. residents. A married couple would count as a single shareholder. Additionally, S corporations can only issue one class of stock, and economic interests must be allocated proportionally in relation to ownership interest. Voting rights may be allocated disproportionately, however.

Limited liability company (“LLC”)

A limited liability company is a business structure which is comparatively simple and easy to administer. Limited liability companies are formed by filing articles of organization with the relevant state authorities. LLC’s have members who possess ownership interest in the LLC, and managing members supervise, manage, direct and operate the LLC. In general, LLC formation and administration is less complex than that of a corporation. The simplicity of formation and administration and flexibility of tax status are some of the main advantages of the LLC structure. LLCs must elect whether to be taxed as a C corporation, S corporation, partnership, or sole proprietorship (in the case of a single member LLC).

Limited liability companies typically utilize what is known as an operating agreement to designate the ownership structure and relationships between members as relates to capital accounts, earnings and management of the LLC.

The main disadvantages of the limited liability company structure as compared with a corporate structure relates to the entity’s lifespan as well as issues related to raising capital. For example, a corporation will continue in perpetuity upon death of one of its shareholders, while an LLC will typically be dissolved. Corporations, in particular C corporations, are advantageous for raising capital in that their shares can be registered and the company can become publicly traded. This is typically not the case with LLC membership interests.

Another advantage of a limited liability company when compared with an S corporation relates to shareholder composition. An S corporation has numerous restrictions on shareholder composition as relates to the number of shareholders and the nature of those shareholders. An LLC, on the other hand, has few of such restrictions. LLC shareholders can be unlimited in number and can be individuals, corporations, partnerships, and other LLC’s.

Partnerships

A partnership is a business arrangement where the individuals or entities involved share in the profit and loss of the business. Unlike a corporation, and depending on the particular structure of the partnership, partners may or may not have liability related to the business activities. Earnings and other gains are typically passed through to the partners who are then responsible for reporting these gains on their individual tax returns. Similarly, expenses, assets and liabilities are assigned to the partners.

A major advantage of a partnership is that the income passes through to the partners and is thus taxed only once. This is on contrast to a c corporation which, as discussed previously, is subject to taxes once at the corporate level and again at the shareholder level, resulting in “double taxation”.

In one structure, known as a limited partnership, there are two types of partners: limited partners and general partners. Limited partners do not actively participate in the business activities of the entity and are not liable for the activities of the partnership to any extent that exceeds their ownership interest. General partners are typically responsible for managing the business activities of the entity and are subject to liability. This is in contrast to an LLC, where both the managing members and non managing members are typically protected from liability in most cases.

There are other partnership structures, including limited liability partnerships and general partnerships, which will not be discussed in detail here.

Sole proprietorship

A sole proprietorship is a small business structure where the business owner has no legal entity to separate his/herself from the business. The business is operated under the business owner’s name or a trade name and the business owner is personally responsible for the debts and obligations of the business. This is in contrast to a corporation or a limited liability company, which is separate and distinct from its shareholders or members and typically provides some amount of liability protection to the owners and operators.

A sole proprietorship may or may not have its own employer identification number (EIN). As EIN is required in certain circumstances, for example where the proprietor wishes to hire employees.

While a proprietorship may have a trade name, such a name does not create any legal distinction between the business owner and the business.

Due to its being indistinguishable from its owner, a proprietorship does not file its own tax return. Instead it typically reports business income and expenses on schedule C of the business owner’s personal tax return.

The main advantage of a sole proprietorship is simplicity and ease of formation and administration, while its main disadvantages are lack of protection from liability as well as limited ability to raise capital.

Bookkeeping methods for managing the balance sheet and other books of a business or household include the cash basis method and the accrual method.

With the cash basis method of accounting, expenses are accounted for as they paid, and revenues are accounted for when they are received. This method is simpler to administer but portrays a less accurate picture of the financial condition of the business or household.

With the accrual accounting method, expenses are accounted for as they are incurred, and revenues are accounted for when they are earned. This method is more complex to administer and track but provides a more accurate picture of the financial condition of the business or household at any point in time.

The accrual accounting method gives a more accurate picture of the financial condition of a business, as it removes any inaccuracies in the balance sheet related to expenses being paid late and revenues being received early.

In order to illustrate the difference between these two methods, consider an example where an insurance policy’s annual premium is paid in advance. In this scenario, the premium would be booked as an expense in one lump amount when the cash basis method is used. Should the accrual method be used, the annual payment would remain on the balance sheet as a prepaid expense and would be amortized over the duration of the annual term.

Consider, similarly, revenue received in advance for a contract which is 3 months in duration. Should the cash method be used, this revenue would be booked in one lump sum. Should the accrual accounting method be used, the revenue would be booked piecemeal over the three month contract period.

As can be seen from both of these examples, the accrual method is a more accurate method in terms of describing the financial state of the business or household because it takes into account the effect of revenue received but not yet earned, and expenses paid but not yet accrued.

Tax exempt organizations are entities which qualify for tax exempt status under one of several IRS sections. These organizations are typically corporations, trusts, or certain non incorporated entities.

The most common tax exempt organization is a charitable organization, frequently known as a 501(c)(3) organization. Other tax exempt organizations include Social Welfare Organizations, Labor Organizations, Trade Associations, Social Clubs, Fraternal Societies, Employee Benefit Associations, and Political Organizations.

501(c)(3) organizations must be organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to animals or children.

Charitable organizations are the most common type of 501(c)(3) organization and are discussed the most frequently. Charitable organizations can be one of two types, a public charity or a private foundation. Private foundations typically receive most of their income from investments and endowments, while public charities typically receive most of their income via contributions from individuals and the government.

Certain donors who make contributions to qualified 501(c)(3) organizations are eligible to deduct such contributions. Additionally, these organizations are able to avoid federal income taxes on the the difference between their revenues and expenses.

Charitable organizations are typically prohibited from supporting political candidates, and are typically subject to limits on lobbying.

Municipal bonds are bonds issued by municipalities, oftentimes for the purpose of funding infrastructure or other public works projects. One of the major advantages of municipal bonds is that their interest is exempt from federal income tax, making them especially attractive to investors in high tax brackets.

Municipal bonds can be either general obligation bonds or revenue bonds.

Revenue bonds are backed by revenue generating municipal projects including stadiums, toll roads, and transit projects such as New York State’s Metropolitan Transit Authority. Because they are not backed by the full faith and credit of the issuer, these bonds are typically riskier and subsequently pay a higher coupon than general obligation bonds.

General obligation bonds are backed by the full faith and credit of the municipality issuing the bonds and are serviced using general municipal government revenue including income taxes and property taxes. General obligation bonds are typically less risky than revenue bonds and subsequently pay a lower coupon than revenue bonds.

Like all fixed income instruments, municipal bonds have both interest rate risk and credit risk. From a credit risk standpoint, municipal bonds tend to be slightly riskier than sovereign bonds and slightly less risky than corporate bonds, although this is not always the case. As with other fixed income instruments, the interest rate risk of a municipal bond increases as the duration of the bond increases.

Large cap stocks represent publicly traded equity interest in the largest corporations in the economy, typically in the $10’s of billions and higher. They tend to be well known companies and are usually household names. Large cap stocks tend to be less volatile and risky than small cap stocks but typically offer less opportunity for growth and appreciation.

The shares of large cap companies tend to trade frequently and be more liquid than shares of small cap companies, which oftentimes do not trade as frequently and can be less liquid.

Large cap companies tend to be very established in their line(s) of business and highly diversified in their operations. Many large companies are known as “blue chip” companies due to their high level of quality. The advantage which such companies have is that they tend to be less risky and more stable than smaller companies due to their breadth, size, and access to capital. The main disadvantage which these companies have is that they are unable to grow their revenues and earnings as rapidly as small companies.

As an investor, having a portfolio which is diversified across many different asset classes is a good strategy to manage the risk of your portfolio. By combining large cap stocks with other asset classes such as small cap stocks, international stocks and bonds an investor can tailor their portfolio to their needs.

An investment portfolio, and the underlying asset allocation which makes up the portfolio, is typically designed based upon attributes unique to the investor, such as risk tolerance and time horizon, as well as factors external to the investor. Such external factors include market conditions, macro and micro economic factors, individual security analysis, as well as a large variety of other factors, the details of which will not be discussed here. Here we will focus on two factors which are unique to each investor: the investor’s time horizon and the investor’s risk tolerance. By varying the amounts of stocks, bonds and other asset classes based upon these two factors a portfolio can be designed and managed to meet an investor’s goals and objectives.

Time horizon

Investments with greater returns typically have greater risks, and investments with lower returns typically have lower risks. An investor with a long time horizon can afford to suffer through market downturns; and for this reason could have a larger amount of risky, high return investments than an investor with a short time horizon. An investor with a short time horizon should have a higher concentration of lower return, lower risk investments than an investor with a longer time horizon.

Risk tolerance

An investor with a high risk tolerance can afford to hold a larger concentration of high risk, high return investments than an investor with a low risk tolerance. Such an investor will be less likely to become upset during a market decline and sell their investments. This is a critical aspect of portfolio design and construction, particularly for individual investors. An investor with a low risk tolerance would be more likely to become upset and sell risky investments during a market downturn, incurring a loss. Such an investor should therefore hold a larger concentration of lower risk, lower return investments, as such investments will be less likely to decline in value by significant amounts.

Mutual funds are diversified investment pools which are available to the general public, and are frequently used by investors to provide diversified exposure to securities as part of an overall asset allocation. They are registered securities and are highly regulated. They are frequently referred to as “investment companies”, and are structured in either an “open end ” or “closed end” format. We will review the basics of open end funds and closed end funds here, and discuss some of their advantages and disadvantages as relates to issues such as liquidity and valuation.

Open end funds

Open end funds are mutual funds which can be redeemed or purchased by an investor on a daily basis, and can be done so at the market price, or “net asset value”, of the securities which are held by the fund. The advantage of open end funds is that the investor does not run the risk of being unable to redeem his or her shares at the market price of the underlying securities in the fund. The main disadvantage of open end funds relates to the fact that assets flow in and out of the fund on a daily basis, the net result of which can be a negative impact on fund performance.

Closed end funds

Closed end mutual funds trade on a securities exchange, similar to a stock. The market price of the closed end fund will be determined by supply and demand of the fund on the exchange, and frequently will differ from the net asset value of the fund. A shrewd and disciplined investor can purchase such shares at a discount from their net asset value, and sell them at a premium to their net asset value. An advantage of closed end funds is that there are no daily inflows or outflows of fund assets, so the fund manager is able to manage the assets inside the funds in a long term manner.

Stocks and bonds are some of the most common assets held in accounts by individuals, such as 401K and IRA accounts. Previously we provided an overview of the asset allocation process and how it can be used to customize your investment portfolio based upon your investment objectives, time horizon and risk tolerance. We also discussed briefly how this process can be implemented in your 401K account. Here we will provide a very basic overview of stocks and bonds.

Stocks

Stocks are publicly traded equity interests in businesses, and are typically riskier than bonds. As an asset class, stocks are oftentimes broken down by company size (frequently referred to as “market cap” or “market capitalization”) and geographic region, (such as U.S., developed markets, emerging markets, and frontier markets). Emerging market stocks typically can provide a higher return than developed market stocks, but are riskier. As stocks are overall riskier than bonds, they are usually allocated more heavily to portfolios with a longer time horizon and for individuals with higher risk tolerances.

Bonds

Bonds are debt instruments issued by businesses or governments (both national and local), and are typically less risky than stocks. They are usually allocated more heavily to portfolios with shorter time horizons for individuals with lower risk tolerances.

Holding bonds entails several risks, including credit risk and interest rate risk. Credit risk can be defined as the risk that the issuer will default and fail to make payments of interest and/or principal. Interest rate risk is the risk that interest rates will rise, resulting in a decrease in the present value of the bond principal. Interest rate risk can be somewhat mitigated by holding bonds until their maturity, however this is often difficult for an individual investor who is more likely to be invested in bond funds rather than individual bonds.

Conclusion

Stocks and bonds have different risk and return characteristics. By combining them with other asset classes and weighting their allocation appropriately, an investor can customize an investment portfolio based upon his or her time horizon, investment objectives, and risk tolerance.

Oftentimes it is advantageous from a tax planning standpoint to change an existing traditional IRA account to a Roth IRA account. This is known as a Roth IRA conversion. Roth IRA accounts and traditional IRA accounts have different advantages and benefits. As discussed previously, traditional IRA accounts provide an immediate tax benefit while Roth IRA accounts provide a tax benefit at the time of withdrawal.

A Roth IRA conversion would subject the IRA account owner to income taxes on the withdrawal from the traditional IRA account in the year that the conversion is made. As Roth IRA withdrawals are tax free, the account owner will not have to pay any additional taxes on Roth IRA withdrawals once the taxes on the Roth IRA conversion have been paid. A Roth IRA conversion should only be executed after careful analysis and tax planning has been done, with particular attention paid to income tax brackets in the current year as well as projected income tax brackets in future years.

In some other situations it becomes necessary to change IRA contributions which have already been made. This would occur when the account owner wishes to change traditional IRA contributions to Roth IRA contributions in order to take advantage of the benefits of the Roth IRA, or vice versa. A common example of a recharacterization is when an individual subsequently becomes ineligible for a Roth IRA due to exceeding the relevant income limits, after the Roth IRA contributions have been made. In this case, the account owner can recharacterize those contributions, and typically has until the tax filing deadline, including extensions, to do so.

In today’s low interest rate environment, whether or not to pay off a mortgage early is a question which is often asked and debated. Oftentimes one could benefit more by paying off a loan over a longer time frame, as inflation will tend to degrade the real value of the loan principal over time. In the current low interest rate environment the carrying costs of the debt are minimal. Because a mortgage is a long term obligation, the additional funds can instead be invested in a diversified portfolio of equities and bonds, preferably in a ROTH IRA or ROTH 401k.

Many of the arguments for early mortgage payoff were valid in prior decades, when interest rates were much higher. Take, as an example, the 1990’s when the 30 year rate hovered between 7% and 10%. In these years, it was usually advisable to pay off a loan early, as significant savings could be realized by doing so. As an example, consider a $500,000 30 year mortgage at an 8% rate, which was a typical situation in the 1990’s. By paying off such a mortgage 10 years early, savings of over $300,000, or 60% of the loan principal, could be realized.

Contrast this with a $500,000 30 year loan at a 3% rate, which is more typical in today’s environment. Paying off this mortgage 10 years ahead of schedule would result in savings of less than $100,000, or about 20% of the loan principal. An argument could be made to pay off such a mortgage later rather than sooner, as one could more easily afford to carry the principal and invest the additional funds elsewhere. Meanwhile, inflation will tend to reduce the real value of the loan principal over the 30 year period.

Medicare part C, frequently referred to as “medicare advantage”, provides a means for medicare eligible individuals to obtain their hospital and outpatient medical coverage through private insurance companies. This is in contrast with medicare part A and part B, in which such coverage is administered and provided by the federal government.

Medicare advantage plans vary and have different rules, provider networks and out of pocket costs. Some medicare advantage plans include prescription drug coverage while others do not, and the premiums for these plans are typically paid for by medicare. The private insurance companies and the plans which they provide must be approved by and are regulated by the federal government.

Medicare part D includes prescription drug coverage. As discussed previously, some medicare advantage plans include this coverage while others do not. Additionally, medicare beneficiaries who are enrolled in part A and part B have the options of purchasing stand alone part D prescription drug coverage.

Medicare supplement plans, frequently referred to as “medigap” plans, are private plans which can be purchased by an individual who is enrolled in medicare part A and part B. These plans provide a means for medicare participants to obtain coverage for deductibles, co-insurance, and other out of pocket costs associated with medicare part A and part B. Like medicare advantage plans, medicare supplement plans are regulated by the federal government.

Custodial accounts provide a simple way to gift money to a minor child. They enable the donor to retain control of the account until the beneficiary reaches the age of majority (typically 18 or 21, depending on the state). Depending on the state, custodial accounts include structures such as UTMA (“uniform trust for a minor”) and UGMA (“uniform gift for a minor”) accounts, and they can easily be set up at a bank, broker/dealer or trust company.

Unlike 529 plans, the funds in the UGMA or UTMA account do not have to be used for higher education expenses. UGMA and UTMA accounts do not have any tax advantages as 529 plans do, although contributions can be designed to qualify for gift tax exemptions. The minor child beneficiary of the custodial account will be responsible for paying income taxes on the earnings generated by the custodial account. Keep in mind that income earned by the minor, including in any custodial accounts, will be subjected to the “kiddie tax” and will be taxed at the parents’ tax bracket if it exceeds certain thresholds.

The advantage of custodial accounts is that they are relatively easy and inexpensive to set up. The disadvantage is that there is very little customization available. For example, with both the UGMA and UTMA custodial accounts the beneficiary will have full access to the accounts when reaching the age of majority, and there is no way to prevent or change this. This is in contrast to a trust, which while generally more expensive and cumbersome to set up, can be customized to suit your individual needs.

Medicare coverage is broken down into parts A, B, C and D. Medicare part A (hospital coverage) and medicare part B (medical coverage) are run by the federal government. Part C (medicare advantage) and part D (medicare supplement) are administered by private insurance carriers and are approved by the federal government to replace or supplement parts A and B.

How you manage your medicare coverage is an important part of financial planning if you are of the age where you qualify for benefits of any kind. Here we will provide a very basic overview of medicare parts A and B and how they work. In subsequent articles we will discuss medicare parts C and D and how you can use these private plans to actively manage your individual situation.

Medicare part A – hospital coverage

Medicare part A is hospital coverage, and you do not have to pay premiums for this coverage if you are age 65 and you meet certain requirements. Medicare part A covers medically necessary services required to treat a disease or condition. These include hospital care, skilled nursing facility care, nursing home care, hospice, and home health services.

Medicare part B – medical coverage

Medicare part B is outpatient coverage, and you must typically pay premiums for part B. You must under many circumstances enroll in medicare part B when you are first eligible. If you do not, you will have to pay a penalty in the form if higher premiums when you finally do enroll, unless you meet certain exceptions. Medicare part B covers medically necessary supplies and services needed for diagnosis or treatment of your condition. This includes services received at a doctor’s office, clinic, hospital, or other health facility.

Banking products, such as checking accounts, savings accounts, and certificates of deposit (“CDs”), are designed to serve a variety of purposes for consumers and businesses who utilize these products. A checking accounts is designed to conduct transactions, while savings accounts and CDs are designed for the storage of short term and medium term cash reserves. For an individual or family cash reserves are oftentimes maintained as an emergency fund or to fund short term or medium term financial needs or objectives.

Checking accounts

A checking account is designed to conduct a larger volume of transactions than a savings account. There is typically no limit on the number of monthly transactions in a checking account; banks may even encourage a larger volume of transactions through various means. Checking accounts may have higher fees, and typically pay lower interest rates than savings accounts. They are designed to fund immediate financial needs.

Savings accounts

A savings account typically has a lower fee and pays a higher rate of interest than a checking account, and is designed to be accessed and transacted in by the account holder less frequently. There may be monthly limits on the number of transactions which can be conducted, or additional fees if certain transaction limits are breached. These accounts are designed to fund short term financial needs.

Certificates of deposit

A certificate of deposit, or CD, is designed as a vehicle to store cash for a medium term need, typically 3-12 months, although banks frequently issue CDs for much longer time periods than this. In a CD a fixed sum is deposited into the product and can not be accessed for its duration without subjecting the depositor to a withdrawal penalty. The interest rate on a CD is typically higher than that of a savings account, and tends to increase along with the duration of the particular CD product. In some cases, the bank will pay a higher interest rate if the deposit size exceeds a certain amount.

IRA rollovers and transfers involve the tax deferred movement of funds between different retirement accounts. Oftentimes there will be a need or desire to move funds from one retirement account to another. This will occur, for example, after leaving an employer, or when moving your IRA from one financial institution to another. If these movements of funds are conducted in accordance with IRS rules the account participant can avoid taxable events which normally occur when withdrawing funds from retirement accounts.

IRA rollovers

An IRA rollover is the movement of funds from an employer sponsored retirement plan, such as a 401K or 403B plan, to an individual retirement account (“IRA”). If done in accordance with IRS rules, the rollover will not result in a taxable event for the account participant.

In rare cases it is possible to perform a direct, trustee to trustee transfer of funds from the 401K plan to the IRA. Such transfers are typically initiated by the receiving financial institution or trustee.

In the majority of cases, however, rollovers are accomplished by having the 401K plan custodian generate a check payable to either the receiving financial institution which has custody of the receiving IRA account or directly to the 401K participant. In order to comply with IRS rules and not have the 401K plan withdrawal be treated as a taxable event, funds must be rolled over to the receiving IRA account within 60 days. This is true even in cases where the 401K plan custodian generates a check payable to the custodian of the receiving IRA account.

IRA transfers

An IRA transfer is a movement of funds from one IRA custodian to another. These transactions can usually be executed by means of a direct, trustee to trustee transfer, typically initiated by the financial institution on the receiving end of the transfer.

Similar to how IRA rollovers are executed, a transfer can be accomplished by having the financial institution which has custody of the IRA generate a check payable directly to the receiving financial institution. A transfer executed in this manner must be completed within 60 days in order to avoid having the withdrawal deemed to be a taxable event.

Alternatively, an indirect transfer can be accomplished by having the financial institution which has custody of the IRA generate a check payable to the account holder. The account holder then has 60 days to roll the funds over to the new IRA account at the receiving financial institution or trustee. Keep in mind that oftentimes when performing such an indirect transfer, taxes will be withheld by the outgoing custodian. It is important that the full amount of the withdrawal be rolled over to the new account in order to avoid any taxable event associated with the withdrawal.

Owners of real estate, including home owners, are able to access the equity in their property in several ways, including reverse mortgages, liquidation of the underlying real asset, and using the property as collateral for a loan. A home equity line of credit or loan is a way to use the equity in a piece of real estate as collateral for a loan or line of credit. The loan or line of credit places a lien on the real estate that is used as collateral, which has the effect of reducing the amount of equity in the real property. Here we will discuss the situation where a homeowner uses their primary residence as the collateral for this credit. In this scenario, the interest on the loan or line of credit is typically tax deductible.

Home equity loan versus line of credit

A home equity line of credit (frequently known as “HELOC”) is a facility which can be accessed or drawn upon by the borrower. Funds can be drawn during the draw period, and the payment amount during the draw period is usually based upon the amount drawn and the interest rate on the loan. Oftentimes it is only required to make interest payments during this period, and in some situations no payment is required. The length and terms of the draw period vary. Once the draw period ends, the repayment period usually begins, and the required payments during the repayment period are typically higher than during the draw period. In some cases, a single lump sum payment, known as a “balloon payment”, is due at the end of the draw period, which can expose the borrower to significant risk. Interest rates on a HELOC are usually variable.

A home equity loan is a lump sum loan amount, secured by the equity in the home, which must be paid according to a fixed term or schedule. Unlike with a HELOC, which usually has a variable interest rate, the interest rate on a home equity loan is typically fixed.

Any home equity loan or line of credit contract or agreement should be understood carefully and in detail before executing or signing. Careful attention should be paid to interest rates and repayment periods and terms. Keep in mind that you typically have the right to cancel any home equity loan or line of credit contract within three days of signing.

Life insurance taxation is an important subject as relates to your overall financial situation. Life insurance contracts have several tax features which make them unique and advantageous as an asset class. We will discuss several aspects of life insurance taxation. We will discuss tax advantages of life insurance here related to the death benefit, the withdrawal or surrender of the cash value, and the dividends from the policy.

Taxation of the death benefit

Death benefit payments are typically paid income tax free to the beneficiary. They can, however, be subject to the estate tax. There are various strategies for managing the estate tax liability including irrevocable life insurance trusts (“ILITs”). This is a complex subject and we emphasize the importance of consulting with the appropriate advisers in carrying out such estate planning strategies.

Taxation of cash value upon withdrawal or surrender

The cash value of the life insurance policy can be withdrawn tax free up to the basis of the policy, after which point the cash value is taxed. This is a unique and advantageous feature of life insurance and is known as the first in first out (“FIFO”) convention. It is important that the life insurance policy meet certain requirements in order to qualify for FIFO treatment. If a life insurance policy is over funded as per these rules it could be classified as a modified endowment contract (“MEC”) which would deem it to be treated as an annuity for tax purposes, which would include last in first out (“LIFO”) treatment of the gains as well as a 10% penalty for early withdrawals (prior to age 59 1/2).

Assets held overseas or denominated in a foreign currency can expose your investment portfolio and assets to currency risk. Here we will discuss the risks associated with holding stocks, bonds, real assets and cash denominated in a foreign currency, and options for mitigating this risk via hedging. Overall we believe that hedging as an investment strategy is an expense which will have the net effect of reducing the return of the portfolio over time.

Currency risk of stocks and bonds

The effect which exchange rate risk has on overseas assets such as stocks and bonds is a very complex subject. The performance of the foreign business issuing the securities is effected by currency risk due to its inventory, receivables, and other assets being denominated in the country’s currency. When stocks or bonds are issued and denominated in a foreign currency, they typically pay interest or dividends in that currency. The investor is therefore exposed to currency risk in a variety of ways.

A portion of these currency risks can be hedged using currency futures, however keep in mind that there are inherent costs associated with hedging. Additionally, there may be an underlying need to own assets denominated in the currency of another country, as discussed more below.

Currency risk of real assets

There may be an underlying need to hold assets in a foreign country, and real assets held overseas, such as real estate and commodities, can serve as both a currency hedge and an inflation hedge. An instance of this is where real property is held in a country to which the holder of the asset intends to return to at a future date, for example to retire.

Rental real estate can be an excellent investment. Real property offers a significant opportunity to obtain income and capital appreciation for an investor. It also has many advantages to an investor from a tax perspective. These advantages include the ability to exchange property on a tax deferred basis, as well as the ability to write off numerous expenses associated with the property, including depreciation and depletion of the underlying assets.

Tax deferral

Investment property can qualify for a “like kind exchange” which is known as a section 1031 exchange. Under a section 1031 exchange, the investor can defer gains on the property as long as the proceeds from the real estate sale are re-invested in another property. Certain requirements must be met, including the identification of a replacement property and subsequent closing on that property within certain time frames, as well as the use of a qualified intermediary to transfer the funds from one property to another. It is important that such an exchange be done in consultation with the appropriate advisers as the rules are complex.

Deduction of investment expenses

In addition to expenses associated with operating the real property including contractor and employee expenses, real estate taxes, utilities, repair costs, and travel related to running and managing the property, real estate investors can also deduct depreciation of the property and of many of the fixtures inside the property. There are certain IRS conventions which are used to depreciate property, including the accelerated cost recovery system (“ACRS”) as well as the modified cost recovery system (“MACRS”). Under these systems the depreciation is calculated based upon the current basis in the property as well as the number of years remaining in the cost recovery period. A unique feature of deducting depreciation expenses is that the cash flow of the property is not affected. In certain situations an investor can operate a property which has positive cash flow but which shows a loss on the income statement, resulting in a tax advantage.

We believe that individual or household finances should be managed as those of a business are managed, therefore financial statements, including the balance sheet, income statement and cash flow statement are very important. We discussed the former two in previous articles. Here we will discuss the personal income statement and how it is constructed. Unlike the balance sheet which is the snapshot of the household at a particular point in time, the income statement is related to how financial assets move through the household or other entity within a specified time period, for example monthly, quarterly or annually.

On one side of the income statement are items which may include employment income, dividend and interest income, pension income, and social security income. On the other side of the income statement are items which may include fixed and variable expenses as well as payments to service liabilities such as mortgage payments, student loan payments and credit card payments.

Balance sheets are financial statements used by businesses. Here we will describe the balance sheet for an individual or family. Your balance sheet is a snapshot of your assets, liabilities and capital at a particular point in time. It gives you a sense of what you own, what you owe, and what you have invested.

Assets

Assets include cash, marketable and non marketable securities, antiques and collectibles, real estate, cash value of life insurance, annuities, vehicles, prepaid expenses, and wages and other income receivable.

Liabilities and net worth

Long term liabilities include secured and unsecured installment loans, mortgage loans, credit card balances, and student loans. Current liabilities include unpaid bills and loans which are due to be paid off within the next year. Net worth is the differential between the assets and liabilities, and therefore assets will always be equal to liabilities and net worth.

Taxes are levied upon a decedent at both the federal and state level. At the state level, such taxes are commonly referred to as inheritance taxes while at the federal level such taxes are commonly referred to as estate taxes.

Estate taxes

The estate of the decedent is subject to estate taxes if it exceeds certain an exemption threshold, which is $5,430,000 for an individual and $10,860,000 for a married couple for the 2015 tax year. The size of the estate can be reduced by making gifts up to the the annual exclusion limit ($14,000 per person in 2015). Gifts over and above this exclusion limit will trigger the gift tax and will require that a gift tax return be filed. Gifts to certain persons and entities can be unlimited and are not subject the the annual exclusion limit. These include gifts to your spouse, gifts to certain charities, gifts related to certain higher education expenses, and gifts related to certain medical expenses.

Where assets are “located” has a significant impact from both a tax perspective and an asset protection perspective. Assets can be placed/located in retirement accounts, taxable accounts, life insurance policies, annuities, trusts, corporations, and LLC’s. This can be a complex subject overall. We will briefly discuss here a comparison between ROTH retirement accounts and traditional retirement accounts, a comparison between retirement accounts and taxable accounts, as well as some discussion of life insurance policies and annuities.

Retirement accounts – ROTH accounts versus traditional accounts

Assets in retirement accounts typically accumulate and grow tax deferred (in the case of traditional 401K, 403B and IRA accounts) and in the case of ROTH 401K and ROTH IRA accounts can be withdrawn tax free. For this reason, a case can be made for placing assets which have the capacity to generate the largest long term gains (such as small cap stocks) into ROTH accounts, while placing the assets which are lower risk and do not have the capacity to generate large long term gains (such as U.S. treasury bonds) into traditional accounts. A careful analysis should be done of the tax bracket now and the expected tax bracket during retirement.

Taxable accounts versus retirement accounts

As taxable accounts do not have any tax deferral features, a case can be made for placing growth, non dividend paying assets into these accounts, and placing dividend paying assets into retirement accounts and reinvesting those dividends and interest. This way, the investor can benefit from the long term capital gains taxes which are typically lower than the income taxes which are levied on dividends and interest.

Annuities versus taxable accounts

Assets in annuities grow tax deferred, with the basis determined by the amount contributed to the annuity. For this reason, a case can be made that it is advantageous to place dividend-paying assets into annuity contracts while placing non-dividend paying, long term appreciating growth assets outside of annuity contracts. This way, dividend generating assets can accumulate and grow tax deferred inside the annuity contract, and the investor can benefit from the lower capital gains taxes on growth assets held outside the annuity contract.

Owning versus renting: which is better? We will provide a basic comparison between owning and renting a home. Oftentimes a home is thought of as an investment, however we believe that it is more of a consumption item than an investment item, with the added benefit of serving as an inflation hedge for the owner.

As an example of this, consider a 30 year fixed mortgage note which is paid exactly as agreed. Over this 30 year period, rents and wages will rise, however the mortgage payment will remain constant. There may be times when housing prices rise at a substantial rate however research has shown that in the long run housing has merely kept pace with inflation since 1890.

A large part of this is due to the large transaction costs incurred during purchase and sale of real estate. These costs are much higher for a typical consumer purchasing a home than they are for typical professional real estate investors, who purchase real estate regularly and thus enjoy an economy of scale due to their expertise and the volume of transactions which they engage in. Owning a home also results in additional time which must be spent by the homeowner in maintaining the home, while renting will typically require less time and expense on maintenance.

Cash flow statements, income statements and balance sheets are financial statements used by businesses to record and manage their financial position. Here we will discuss cash flow statements as relate to an individual, family or household. The cash flow statement shows how much cash is generated in a particular amount of time, for example monthly, quarterly or annually.

Disability insurance protects your income in the event of a disability preventing you from earning income through employment. Social security has a disability program which provides some amount of coverage in the event of a long term disability. The social security disability program provides long term benefits with an elimination period of 6 months. What this means is that a person must be disabled for six months before they can begin collecting benefits. More information about the details of this coverage can be found on your social security statement, or by accessing your social security benefit information online at www.ssa.gov.

In addition to benefits provided through social security, you can also obtain coverage through a group plan such as an employee group or union, or purchase individual coverage through a private insurance carrier. Private disability insurance is subject to stringent underwriting requirements, and pricing is based upon occupation, health, benefit amount, and time frame of benefits which are provided.

Private disability insurance can be either short term or long term. Short term disability insurance covers disabilities lasting from a few weeks to several months or a year, while long term disability insurance coverage begins after an elimination period of several months to a year and lasts anywhere from a few years up to retirement age or longer.

We will discuss how to protect against the most common risks – unemployment, disability and death.

Unemployment

Unemployment insurance is typically provided by state or federal government programs. Private insurance for this type of issue does not exist for the most part, and in order to take a proactive approach to managing this risk an emergency fund should be established.

Disability

Disability insurance is provided by the federal government through the social security program, and in some situations is mandated by states through workers compensation laws. Many employers and unions provide disability insurance for their employees and members. A proactive approach can be taken by purchasing private insurance coverage as well. Pricing for this type of coverage is typically based upon age, health and occupation. Disability insurance can generally be broken down into two types: short term disability insurance (STD) and long term disability insurance (LTD). Short term disability programs typically cover events lasting from a few weeks to a year, depending on the particular coverage, while long term disability coverage typically covers events which are long term in nature. Disability insurance policies are typically subject to an elimination period, which is the minimum amount of time which the disability must last in order for the policy holder to begin collecting benefits.

Dependent survivors

Coverage to protect dependent survivors in the event of death of a breadwinner is typically provided by purchasing life insurance. Social security also has a dependent survivor’s benefit program, where benefits are provided to a surviving spouse as well as to surviving children. Details of this coverage can be found in the social security statement.

When you decide to take your social security retirement benefit will have a significant impact on the amount of the benefits. Your “full retirement age”, according to social security rules, will vary depending upon your birth year, between the range of age 65 if you were born in 1937 or earlier, to age 67 if you were born in 1960 or later. You can take benefits earlier than this, as early as age 62, and receive a reduced benefit amount, or take benefits later than this, up until age 70, and receive an increased benefit amount. The exact amount of your social security retirement benefit amount can be found on your social security statement, which is sent to you annually by the social security administration. You can also access your benefit information online at www.ssa.gov. When you should file will depend on a number of factors including your health and life expectancy and your additional financial resources available to you to fund your retirement.

In many situations a strong case can be made for delaying the taking of social security benefits as long as possible, until age 70, because in many cases this will result in the largest benefit overall. Of course each individual’s situation is different and a thorough analysis should be done taking into account a number of different factors unique to the individual. A financial adviser can assist with the process of analyzing your situation in relation to your balance sheet and income statement, to help you determine the option which best suits your needs.

Retirement income can be broken down into three general categories: income from investments, income from pension plans, and income from social security. Of course, many decide to continue working during retirement so employment, self employment or business income may be available as well.

Investment income

Investments can be used to to fund retirement needs by either generating dividend and interest income or by gradually liquidating the assets over the course of retirement. The main advantage of the first method is preservation of principal, and its disadvantage is that it results in lower income than the second method. The advantage of the second method is larger income, and the disadvantages include depletion of principal and longevity risk related to the assets lasting throughout retirement. In certain cases this longevity risk can be managed by means of insurance contracts such as annuities, however such contracts require the policy owner to give up control over the principal.

Income from pension plans

Defined benefit pension plans are another source of retirement income. Benefits paid are typically a function of age, income received while employed with the company or organization associated with the defined benefit plan, and years of service provided to the employer or organization. Other factors can also impact the income provided by the plan, including whether or not a spousal survivor benefit is included in the plan. Pension plan income is advantageous in that there is no longevity risk associated with the benefits, as benefits are in most cases paid throughout the life of the pensioner. Careful planning should be done with respect to coordinating survivor benefits of the pension plan. In certain cases, life insurance contracts can be purchased in lieu of activating survivor benefits on pension benefits, however a careful analysis should be done before doing so.

Income from social security

Income from social security is the most common source of income for Americans, providing 40 percent of income for persons 65 years old and older according to the Social Security Administration. When to file for social security benefits is an important decision and should be coordinated carefully with other retirement income sources in order to maximize retirement income.

Certain retirement accounts are subject to required minimum distribution rules upon reaching a certain age, typically 70 1/2. At this point, the account participant is required to withdraw a certain amount from the account(s) each year, and these withdrawals are usually subjected to income tax. The participant may withdrawal more than the required amount and still be in compliance with the rule. The rules apply to IRA accounts, SEP-IRA accounts, SIMPLE IRA accounts, 401K plans, 403B plans, 457 plans, and other defined contribution plans. Note that ROTH IRAs are not subject to the rule in most cases.

The amount of the required minimum distribution is based upon age and marital status, and is determined based upon mortality tables. The details of the calculation will not be covered here, however most account custodians will calculate the required minimum distribution for the account owner.

Investments can be be taxed in several ways. When they are held inside retirement accounts, taxes are levied upon withdrawals from the retirement accounts based upon the rules related to those accounts. When they are held outside of retirement accounts, they can be taxed on both the income which the investments generate as well as on the gains obtained when the investments are disposed of.

Income

We restrict discussion to dividends and interest here, and how they are treated for the recipient. Income paid in the form of dividends and interest is typically taxable to the recipient upon being paid by the issuer or payer. In the case where dividends are reinvested to purchase additional securities the dividends are still taxed upon being paid. Dividends and interest are typically taxed as ordinary income, the exception being certain “qualified” dividends which are taxed at the capital gains tax rate.

Capital gains

Capital gains taxes are incurred when an asset is disposed of, and are based upon the amount of time which the asset is held. Assets held for one year or less are taxed at the short term capital gains tax rate, while assets held for more than one year are taxed at the long term capital gains tax rate. The amount of the gain is a function of the sales price and the cost basis of the asset. The table below shows the capital gain tax rates for their corresponding income tax bracket.

An emergency fund consists of cash assets held in savings accounts, checking accounts, money market accounts, or CDs for the purpose of meeting unexpected expenses. How much of an emergency fund you should maintain varies depending on a variety of factors including the amount of your income and the stability of that income. Having more reserve assets than necessary can deprive you of the opportunity to earn a substantial rate of return on your liquid assets, while having an inadequate amount of cash reserves can subject you to the risk of having a cash shortage should an unexpected emergency event arise.

On one end of the spectrum is an individual or family with steady, predictable income. A family in this situation could likely survive with an emergency fund consisting of three months living expenses. On the other end of the spectrum is an individual or family which relies on business or self employment income. Such a family would likely require a much larger emergency fund, consisting of as much as twelve months of living expenses.

It is also important to perform a risk analysis to determine the likelihood of an emergency event occurring and the risk management systems in place to plan for the possibility of such events occurring. This includes analyzing existing insurance coverage with respect to coverage amounts as well as deductibles, as well as cash reserves held in vehicles such as health savings accounts. For example, individuals or families who self insure will need to maintain a higher cash reserve in an emergency fund than those individuals or families who maintain a substantial amount of insurance. Similarly, having insurance coverage with high deductibles will necessitate having sufficient cash reserves to pay those deductibles should a claim arise.

In most cases, you will be subjected to a 10% penalty tax on withdrawals made from an IRA account (for a ROTH IRA, this penalty is levied on the earnings only) if the withdrawals are made prior to age 59 1/2. Keep in mind that you will always pay regular income taxes on withdrawals from traditional IRA accounts if you were able to deduct all of your contributions and that there are no exceptions to this. If you did not deduct all of the contributions the situation is a bit more complicated. There are, however several exceptions which will allow you to avoid paying the 10% penalty tax. In this article we will cover three of these exceptions: an exception related to being a first time home buyer, an exception related to qualified higher education expenses, and an exception which relates to taking equal periodic payments from your account.

First time home buyer exception

If you are using the IRA funds for a down payment on your first home, you may withdraw up to $10,000 without paying the 10% penalty tax. You will, however, still have to pay income taxes. In order for the home purchase to qualify as a first time home purchase, you must not have owned a home within the previous two years. If you are married you and your spouse may each withdraw up to $10,000 from your IRA for the purpose of making a first time home purchase.

Higher education expense exception

If you withdraw funds from your IRA to pay for qualified higher education expenses of yourself, your spouse or your child you will not have to pay the 10% early withdrawal penalty tax. Qualified higher education expenses include tuition, books, supplies and equipment required for enrollment at an eligible higher education institution.

Equal periodic payments exception

There is another exception to the early withdrawal penalty which involves taking equal periodic payments from the retirement account beginning at a time prior to age 59 1/2 and continuing for 5 years or until age 59 1/2, whichever is later. The rules for using this exception are complex and we emphasize the importance of consulting with a financial or tax adviser when using this exception.

Auto financing can be accomplished in several ways. Here we will briefly discuss a comparison of leasing versus buying.

Auto leasing

The advantages of leasing include lower down payment and lower monthly payments. Disadvantages include limited mileage, no equity in vehicle, and being held responsible for excessive wear and tear

Auto buying

The advantages of purchasing a vehicle include equity in vehicle, no mileage restrictions, and no issues with excessive wear and tear. Disadvantages include higher down payment and higher monthly payments.

Credit scores are metrics which are used by lenders or other parties in conjunction with other factors to evaluate the risk which you would pose to them if they did business with you. They are most commonly used in the loan origination process but are used in the insurance industry as well. We will cover the basics in this article as relates to how credit scores are calculated as well as how they are used by lenders in determining whether or not you will qualify for a loan.

What factors go into a credit score?

Much of the mechanics behind how a credit score is calculated is proprietary and is not disclosed to the public, however some basic information is provided by the credit bureaus related to the scoring system. The main factors which determine a credit score, in order of importance, are payment history, credit utilization, length of credit history, number of credit inquiries, and credit mix. Payment history is related to the number of late payments and the total number of payments, and is intended to measure the timeliness of payments made in the future. Credit utilization is the amount of outstanding credit in relation to the total amount of credit available, and is intended to measure how responsibly available credit resources are managed. Length of credit history is related to the amount of time for which accounts have been in existence, and is intended to measure credit tenure. Number of credit inquiries is related to the amount of time which credit has been applied for, which is reflective of new credit accounts. Credit mix is related to the different types of accounts – mortgage, installment loans, student loans, and revolving lines – in the credit profile.

For many individuals and families the purchase of a home is the largest purchase they will make in their lifetime, and determining how much to spend is therefore very important. How much of a house you can afford will depend on the amount of your income as well as the stability of your income. The lender or originator of the mortgage will be happy to tell you how much home you can afford according to their standards, but these standards are designed to manage their risk, not yours. Although oftentimes your interests happen to be aligned, it is important to do your own careful analysis of your financial situation before purchasing a home. In this article we will discuss ways to determine how much home you can purchase using an analysis of your income, cash flow, assets and liabilities, and financial objectives and goals.

Bank/lender underwriting standards

The bank, lender or originator of the mortgage has certain guidelines which they use to determine whether or not you meet their criteria. The two most important metrics which they use are the “front end ratio”, which is designed to measure the house payment in relation to your gross income, and the “back-end ratio”, which is designed to measure your total long term liabilities in relation to your gross income. Other factors are used as well, but these two metrics are the ones which are most easily quantifiable. A standard which is frequently used for a good credit score is a 28% front-end ratio and a 38% back-end ratio. In other words, if your gross monthly income is $10,000 your principal, interest, taxes and insurance can not exceed $2,800 per month. Similarly, your principal, interest, taxes, insurance, installment loan payments, credit card payments, and student loan payments combined can not exceed $3,800 per month. Note that loans which are scheduled to be paid off within the next 12 months are considered a current, not long term liability and are thus not included when calculating the back-end ratio.

According to the Social Security Administration, over half of the elderly in the United States receive more than half of their income from social security, and in 2015 social security benefits accounted for almost 40% of the income of the elderly. Besides providing old age benefits, social security provides protection related to disability as well as benefits for dependents of a decedent. We will focus primarily on retirement income benefits in this article.

In order to qualify for social security, you must first acquire 40 credits (if you were born before 1929, you may need less). You can obtain up to four credits per year, and in 2016 you would have earned one credit for each $1,260 of covered earnings. So if you had earned $5,040 in 2016, you would have earned the maximum four credits for that year. Once you have earned the required 40 credits, you qualify for retirement benefits, and the amount of your benefits will depend on your earnings throughout your working life.

The retirement benefit amount will depend upon the age at which benefits are filed for, with “full retirement age” being the benchmark . Benefits will be higher if taken later than full retirement age, and lower if taken earlier than full retirement age. Full retirement age will vary depending upon your birth year. Details of your retirement benefits can be found in your social security statement, which is sent to you annually, and can also be accessed online at www.ssa.gov.

As a small business owner, you are able to take numerous tax deductions against your business income. How these deductions are taken will vary depending on whether your business is structured as a sole proprietorship, corporation or partnership. This article will restrict the discussion to the sole proprietorship situation, which includes single member LLC entities which have elected to be treated as sole proprietorships.

This article will cover deductions which are taken on Schedule A of the IRS form 1040. Filers are entitled to either take the standard deduction (for 2016 these amounts are $6,300 for single and married filing separately, $12,600 for married filing jointly, and $9,300 for head of household) or itemize certain deductions. These deductions include mortgage interest (including certain “points”), medical and dental expenses, charitable contributions, certain taxes, casualty, disaster and theft losses, and certain miscellaneous expenses. Some of these deductions are subject to certain thresholds, for example medical and dental expenses are only deductible to the extent that they exceed 10% of adjusted gross income (“AGI”).

Retirement account withdrawals

How should withdrawals be taken from retirement accounts? Factors include investment style and the amount which is withdrawn each year. The manner in which withdrawals are taken from retirement savings account has a significant impact on how long these assets will last. A common practice in the financial services industry is to use Monte Carlo simulations to estimate probabilities of certain outcomes occurring with respect to how withdrawals will affect the retirement assets over time. In this article we will illustrate how retirement account withdrawals can have different results by using two simple examples.

It is often tempting to take a loan or withdrawal from a retirement account to satisfy a financial need such as making a down payment on a house or paying off another debt. Taking such loans and withdrawals is highly discouraged as it depletes retirement savings and can have significant impact on these retirement savings in the long run. It is a serious decision which should not be taken lightly. In cases where retirement savings must be accessed prior to retirement, a loan has an advantage over a withdrawal in that it will not result in taxable income as long as it is paid back according to its terms. However, certain retirement accounts allow loans while others do not. This article will discuss the rules applying to different types of retirement accounts.

IRA loans – generally prohibited

Generally a loan can not be taken using an IRA. Using an IRA as collateral for a loan is prohibited by IRS rules, and can result in the IRA becoming disqualified. There is an IRS provision which allows 60 days to rollover or transfer an IRA to another custodian if the distribution from the IRA is paid directly to you. Keep in mind that in this scenario the taxes are withheld from the distribution so you will need to supply additional funds to complete the rollover or transfer.

401K loans – take with caution

In many cases a 401K participant can take a loan against their 401K account balance, if the particular plan allows loans. You can check the plan document or summary plan description, or check with your company’s HR department to see if a loan is permitted. Taking such a loan is usually quick and easy and is not subject to any underwriting processes. The installment payments made on the loans are usually made through payroll deduction from the participant’s paycheck. 401K loans must be paid back according to their terms in order to avoid being deemed to be a distribution and thus subject to taxes. The loan terms are usually five years or less, unless the loan is used to purchase a primary residence, in which case it can be longer. Keep in mind that if you are separated from service with your employer while the loan is outstanding, it must be paid back in full according to its terms, usually within 60-90 days of termination, or be deemed to be a distribution and thus be taxable. “Interest” which is charged on the loan is typically paid back into the participant’s account as payments are made.

If you have a defined benefit employee pension plan provided by your employer in the United States, you are one of the lucky ones in that these plans are not offered as often as they used to be. In recent decades a shift has occurred in the retirement plan landscape away from traditional defined benefit pension plans and toward what are known as defined contribution plans, specifically 401K and 403B plans. This has resulted in the risk related to funding retirement being shifted from having been borne by the employer to being borne by the employee. If you are of the relatively few who still has a defined benefit plan, this article will explain some of the basic things you should know related to planning your retirement as relates to your pension plan.

A hardship withdrawal can be taken from a 401K plan in certain situations. Under most circumstances it is not advised to withdraw funds from an IRA or 401K account prior to retirement. You will be subjected to income tax on the withdrawals at both the federal and likely state and local levels, as well as a 10% penalty tax if the withdrawal is taken prior to age 59 1/2 (unless you meet certain exceptions). Perhaps more importantly, a withdrawal prior to retirement will have the effect of depleting your retirement savings as well as the future earnings on these savings.

In the case of a hardship withdrawal, you will need to meet certain requirements related to your hardship. You will be unable to make contributions to the plan for a period of six months subsequent to the hardship withdrawal. If your employer makes matching contributions to the plan, these will be suspended as well.

Wills

Trusts

A trust is a legal entity created under state law which allows trustees to manage assets on behalf of beneficiaries. They are oftentimes constructed in order to control, restrict or limit access to the trust assets.

Estates

An estate is a legal entity which is created upon either a bankruptcy filing or the death of an individual, and consists of all of the assets and liabilities of the individual.

Life insurance policies are contracts which are designed to protect the income or assets of the insured person in the event of his or her death. There are many different types of policies including term insurance, whole life insurance, and universal life insurance. We will briefly review each of these types of policies here.

Term Insurance – rental of coverage

With term insurance, the coverage is paid for a number of years, after which point the policy either terminates or becomes prohibitively expensive. Term insurance is usually used to protect the income of a wage earner supporting children or debt such as a mortgage, and is typically the least expensive type of life insurance coverage. The most significant advantage of term insurance is its low cost and its most significant disadvantage is its temporary nature and the fact that it usually will cover a person only in their younger years, when a claim is less likely to be filed. Having term insurance is sometimes referred to as “renting” coverage as the policy holder does not have any equity in the policy and only pays for the coverage for the amount of time for which it is in force.

Whole Life Insurance – purchase of coverage

Whole life insurance is frequently referred to as “permanent” insurance, in that the coverage will remain in force for the duration of the insured’s life, as long as the premiums are paid. This type of coverage is usually used in estate planning, and is typically the most expensive type of insurance. Many types of whole life policies are “participating”, in that the policy holder is entitled to receive periodic dividends from the insurance carrier. Whole life policies have a cash value which can be accessed by the policy owner by means of withdrawals, surrender, or loans. Cash value growth inside life insurance policies is tax deferred and is subject to first in first out (“FIFO”) treatment as long as certain requirements are met. What this means is that the tax free basis is withdrawn prior to the gains in the policy, so the policy owner will only be taxed when the amount of the withdrawals exceed the basis in the policy. The “guarantees” provided by whole life policies are backed by the general account of the insurance carrier. This is in contrast to the separate accounts of universal life insurance policies (discussed below), which are titled in the name of the policy holder. Having whole life coverage is frequently referred to as purchasing coverage due to the fact that the policy holder builds equity in the policy.

Universal Life Insurance – flexible coverage

Universal life insurance can be permanent or temporary depending on how the policy is managed by the policy holder. Premium payments are flexible, and the policy will last as long as the policy remains funded. The policy is funded by means of the policy holder making premium payments as well as earnings inside the policy. Similar to whole life insurance, universal life insurance has cash value which can be accessed by the policy owner by means of surrender, withdrawals or loans. The sub accounts of a universal life policy are typically titled in the name of the policy holder and are thus not invested in the general account of the insurance carrier. Universal life insurance can be used for a variety of purposes including estate planning, income protection and debt protection, and its cost depends on how the policy holder chooses to manage the policy. There are several types of universal life insurance coverage including fixed and variable. With a variable universal life insurance policy the funds inside the policy are invested in stocks, bonds, and other investments, and with a fixed universal life insurance policy the funds inside the policy are invested in fixed interest bearing accounts.

Defined benefit pension plans provide an excellent option for small business owners looking to save for retirement. Similar to SEP-IRA’s and 401K plans, business owners can use these plans to save in a tax deferred manner. The advantage of these plans is that they allow for larger contributions for the business owners, and are therefore ideal for highly compensated owners or partners of small businesses. The disadvantage is that they are more time consuming and costly to administer than many of their alternatives. Contributions to defined benefit pension plans are typically tax deductible to the business, and earnings grow tax deferred until they are withdrawn or paid out. Unlike a SEP IRA or 401K plan, contributions must be made every year. The contribution amount is based on a number of factors including age, compensation, retirement age, and assumed rate of return on pension assets. If the business has employees, they must typically be included in the plan.

Which investment options you choose in your 401K or 403B plan can have a significant impact on how your account will perform in the long run. It is recommended that the assets in the 401K plan be allocated according to the time horizon and risk tolerance of the account owner, based upon an asset allocation model. The asset allocation model has been shown to be one of the most critical determinants of long term investment portfolio performance. Many 401K plans have limited investment options, although in most cases (but not always) they will have fund options available for each major asset class. Sometimes there will be an option to invest in a self directed brokerage account, which allows the plan participant to purchase securities on the market, as opposed to choosing the from among the funds which are available in the plan. We recommend following the steps below when determining the appropriate investment options. We emphasize the importance of consulting the appropriate advisers in executing this process:

Below are the income tax brackets for the 2016 tax year. These are the marginal tax rates, in that you will be taxed at each of these levels as your income rises. For example, if you are single and had taxable income of $60,000, your tax would be the sum of 10% of $9,275, 15% of $28,375 ($37,650 minus $9,275), and 25% of $22,350 ($60,000 minus $37,650). Capital gains tax brackets are different from income tax brackets.

A self directed IRA allows an investor to invest in real estate in an IRA account. The IRS code restricts investments in IRA accounts, and certain investments are prohibited (such as art, antiques, S-corp stock, life insurance, and collectibles). Investment real estate is allowed, however, as long as the participant is not benefiting from the real estate in any way. In order to qualify under IRS rules the participant may not use the property in any manner, or receive rental income from the property outside of the IRA.

To invest in real estate, typically the IRA participant must designate a financial institution, in the majority of cases a trust company, as the trustee and custodian of the self directed IRA account. The IRA participant can then direct the trustee to purchase real estate for the IRA. All real estate expenses must be paid from the IRA account, and all income from the real estate must be paid directly back into the IRA account.

As long as the self directed IRA is set up correctly and is compliant with IRS rules, the IRA participant is able to enjoy the tax advantages of the IRA. This includes tax deferral of both the income received from the property as well as capital gains received when the property is sold. In the case of a ROTH IRA, the participant is also entitles to receive tax free withdrawals, assuming that the normal requirements are met.

Selling your home will not necessarily have an adverse impact as relates to taxes. When you sell real estate, you are usually subject to capital gains taxes unless you perform a “like kind exchange”, or section 1031 exchange, or reinvestment of the proceeds into another piece of real property. A 1031 exchange is limited to investment property, however, for which a primary residence typically does not qualify.

There is, however an exception, or exclusion, in the case where you sell your primary residence (up to $250,000 if you are filing single or head of household or $500,000 if married filing jointly). In order to qualify for this exclusion, you must meet certain criteria. Firstly, you must have owned the home and used it as your primary residence in 2 of the 5 years prior to sale. Secondly, you must not have acquired the home through a like kind, or section 1031, exchange during the five years prior to the sale. Thirdly, you must not have excluded the sale of a home during the 2 years prior to the sale of the home which you now want to exclude. If these three criteria are met you can exclude $250,000 in figuring the capital gains taxon the home ($500,000 if married filing jointly).

The efficient market hypothesis makes the overall statement that all available information related to the valuation of an asset is fully reflected in the market price. If it were true, investing in undervalued assets would not be possible because the valuation would already be reflected in the market price. This theory is propagated, discussed and debated mainly in academic circles and has little use related to actually allocating assets or selecting securities. The theory can easily be disproved by simply looking at the track records of the handful of investment managers who have consistently outperformed the market over many decades. A shrewd, disciplined, objective and focused investor can find inefficiencies in the market and identify undervalued and overvalued securities.

Nonetheless, the efficient market hypothesis is a popular theory and therefore understanding its basic tenets is important for any investor.

A stock option gives the owner the right, but not obligation, to purchase or sell shares of a stock at a certain price, for a given amount of time. Companies frequently use stock options as a means to compensate employees. Employee stock options can be broken down into two general categories: incentive stock options (“ISOs”) and non-qualified stock options (“NSOs”).

There are several excellent books in print which were written by extremely successful money managers, and “The Intelligent Investor” by Benjamin Graham is one of them (“The Alchemy of Finance” by George Soros is another one). Graham was Warren Buffett’s teacher and mentor and ran the Graham Newman investment partnership in the first part of the 20th century. This book outlines Graham’s philosophy of value investing. The book is relatively easy to understand for a lay person, and outlines in detail the underlying principals behind Graham’s investment philosophy and how it can be applied to analyzing and valuing individual securities.

529 plans are savings vehicles for the purpose of funding higher education expenses. They have numerous tax advantages, including tax deferral and tax free withdrawals. The withdrawals are typically tax free as long as they are used to fund qualified higher education expenses such as tuition, board, fees, books and other expenses at an eligible school. Under certain circumstances, 529 plan contributions are eligible for a tax deduction at the state and local level.

With a 529 plan, the owner sets up an account for the benefit of a child, grandchild, or other family member (the beneficiary). Unlike with custodial accounts, the owner retains control of the 529 plan account, even after the beneficiary reaches the age of majority. The owner also has the ability to change the beneficiary of the account after establishing it. For example, if a parent creates an account for the benefit of one child and that child later decides not to attend college, the beneficiary of the account can be changed to another child.

Keep in mind that 529 plan contributions are considered gifts and are thus subject to the gift tax rules. For 2016, the gift tax exclusion is $14K per beneficiary. Keep in mind that all gifts, not just 529 plan contributions, are subject to this limit. There are rules unique to 529 plans which allow the gift tax exclusion for the next five years to be taken in the current year by making an election on your gift tax return. Using this election you could make a contribution of $70K ($140K for a married couple) to a 529 plan for a single beneficiary in the current year.